What constitutes a quality board?

14-11-2017 | Insight

How to assess what’s happening behind closed doors? One of the key topics for any investor is a company’s governance. The board plays an important role in this respect. As shareholders often only have very basic information about the performance of supervisory boards, we spoke directly with the chairmen and lead independent directors of several companies for over three years. We found that transparency has improved, providing investors with some more insight into the quality of boards.

Michiel

van Esch

Specialist Governance and Active Ownership

Speed read

The publicly listed company, in which ownership and management are separate, is inherently faced with an agency problem. This means that management’s actions and interests might not always be aligned with the interests of shareholders or other stakeholders. In most markets, the board has a role in countering this problem. It supervises management in the best interest of shareholders and other stakeholders.

From many board members, we hear that responsibilities have increased. The time when people could easily sit on a double digit amount of boards is over. Depending on the market, they are also expected to assess company risk management and compliance systems, set appropriate remuneration and oversee accounting practices.

To meet all of these expectations, people with a variety of qualities are needed Nomination committees therefore need to allocate sufficient time and resources to find appropriate board members.

The role of the board in supervising financial companies

Many critics have attributed at least part of the financial crisis to poor governance practices. Perverse incentives for top management, a lack of risk oversight and poor checks and balances are often cited as causes of irresponsible corporate behavior in the banking industry. Nevertheless, financial companies often score well on many corporate governance practices such as independence criteria for board members, pay-for-performance structures and transparency via all sorts of reporting. Yet box ticking will not help investors to gain good insight into the quality of corporate governance. A different approach is needed.

We started an engagement project with insurance companies and banks in 2014, with the aim to understand and improve 1) the quality of public disclosures and biographies, 2) board nomination processes, 3) independence and objectivity in corporate boards, 4) diversity (in a broad sense) and 5) self-evaluations of board performance.

A tick box approach won’t have the desired effect

A proper analysis of a board takes a lot of time, but much insight can already be gathered from public information. How many of the independent board members have credible experience in the industry? Does the board appear entrenched, judging by average tenures? Do the backgrounds of board members credibly reflect a company’s market? Sometimes companies provide useful disclosures that help investors. Often however, these disclosures are formalistic, which makes this analysis hard to carry out.

Much of our work has focused on making sure companies have good nomination policies. We have found that companies do not need prescriptive rules for nomination, but require guidelines, planning and sufficient time to start a search process. It requires constant attention from the nominations committee and frequent reviews of board composition in terms of skills, gender, experience, etc.

The supervisory board mainly operates behind closed doors

Having a strong composition doesn’t necessarily guarantee the board is going to work well. It simply means that on paper it hasthe right capacities to do so. In practice, shareholders have very little information about the performance of supervisory boards. Whereas executive management can often be judged on several KPIs and have substantial exposure in the media, supervisory board members mainly operate behind closed doors.

Supervisory boards are increasingly reporting on their activities and the evaluation of their performance. A trained eye can read between the lines and assess whether boards are doing more than rubber stamping. Still, the best way to gain real insight is to speak to board members themselves. During our engagement project, we managed to speak with the chairmen and lead independent directors of several boards. These meetings allowed us a peek into the boardrooms of our investee companies and rendered the most fruitful conversations.

All companies met local standards for the required number of independent directors. We had concerns, however, about companies that traditionally held on to dual mandates (CEOs who are also the Chairman of the board) and the level of industry experience of the independent board members. Solvency II helped our cause to a certain extent, by requiring splitting key responsibilities for top management which had led to dualism in several cases.

Three years on

We have seen positive developments in the insurance sector. Transparency and disclosure have improved markedly, making it easier for investors to gain a picture of board composition. Disclosure of board self-assessments has also become more prevalent, giving investors a look behind the scenes. And as for those candidates who gain a seat on the board, whilst more pressure is placed on their time, they also tend to have more relevant skills.

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